Fed may have to hike rates before need clear: Warsh

By IBT Staff Reporter On 09/24/09 AT 10:40 PM

The U.S. Federal Reserve may have to raise interest rates from their currently ultra-low setting near zero before the need to take action becomes obvious, Fed Board Governor Kevin Warsh said on Thursday.

Warsh, in an op-ed published in the Wall Street Journal a day after the Fed left rates unchanged and declared the U.S. economic recovery under way, said the central bank was at a critical transition period, of still unknown duration.

I would hazard the view that prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, Warsh said.

The Fed on Wednesday said that growth had resumed after a severe economic downturn, and Warsh echoed this line while emphasizing that inflation remained in check, allowing policy-makers to leave rates low while the recovery builds.

He said financial markets could provide better forward-looking guides to the development of growth and price pressures than traditional economic data, and picked out asset prices and credit spreads as two important gauges. U.S. stock markets are up 50 percent since March and credit spreads have narrowed.

In addition to cutting interest rates to the bone, the Fed pumped hundreds of billions of dollars into financial markets to prevent them from seizing up during last year's crisis, doubling the size of its balance sheet to over $2 trillion.

Policy makers should acknowledge the heightened costs of policy error. The stakes are high, in part, because the policy accommodation that requires timely removal as the economy rebounds is substantial, Warsh said.

Critics fear that massive increases in liquidity represented in the boost in the size of the Fed's balance sheet could spark inflation as growth picks up steam.

The Fed has said it will exit from its massive monetary expansion to prevent inflation taking hold.

Policy makers should continue to communicate as clearly as possible the guideposts, conditions and means by which extraordinary monetary accommodation will be unwound, including the removal of excess bank reserves, Warsh said.